Obama's Economic Team Frozen in the Headlights, U.S. Economy is in Big Trouble

The personal savings rate has risen to 6.4%. When households save, consumer spending declines and GDP shrinks. The reduction in economic activity can have serious knock-on effects. It can lead to more layoffs as investment sputters as aggregate demand flags. If the downturn persists, asset prices and wages fall leading to tighter credit, deflation and a deepening slump. The good news is that the problem can be fixed.

The government merely needs to increase the deficits to satisfy the net savings desires of the private sector. In other words, the government needs to fill the hole created by the lack of personal consumption. That's all it takes to keep people employed, reduce the output gap, and avoid much of the pain from economic contraction. When the economy returns to trend, government revenues increase and the budget deficits shrink. This isn't theory; it's the way the system works.

Stimulus works because stimulus means spending. Spending IS economic activity, so (by necessity) it increases GDP. Whether it is 'wise' to increase the budget deficits or not is immaterial. That depends on one's own political orientation. But the fact is, stimulus works.

The economy is not effected by our opinions or our political orientation. It's a system. It functions according to the rules which govern its operation. Investment and spending are the lubricants that keep the gears in motion. The economy does not distinguish between public and private spending. It's all the same. If spending and investment are sufficient to generate growth, then the economy will grow. If spending and investment dry up, the economy will grind to a halt. Either way, the economy is merely responding to the amount of stimulus feeding into the system. Policymakers--the Fed and congress--have now decided to cut off additional stimulus even though the economy is still weak and all the data has been revised downwards. Conservatives in the House and senate believe that the budget deficits are too large and that the government must slash spending. Thus, the economy--which everyone agrees is weak--is being further battered by the muddled thinking of ideologues. This is politics; it has nothing to do with economics.

The opponents of stimulus don't believe that the government should meddle in the markets. They think the Fed should allow asset prices to tumble, unemployment to skyrocket, and financial markets to crash. The liquidationist approach is principled, but shortsighted. There's no need to let the economy crash when steps can be taken to soften the blow. The government has the means to support the economy until the private sector repairs its balance sheet and resumes spending. Here's an excerpt from economist Richard Koo in "The Economist" which helps to explain what needs to be done:

"The next move for the Fed, a long overdue one in my view, should be to announce that the US is afflicted with a balance sheet recession, a rare disease that strikes only after the bursting of a nationwide debt-financed asset price bubble. With its asset prices collapsing while its liabilities remain, the private sector is forced to deleverage or minimize debt even with zero interest rates in order to repair its battered balance sheets. The Fed should explain that in this type of recession, monetary policy is largely ineffective because those with negative equity are not interested in increasing borrowings at any interest rate. The Fed’s continued failure to explain the exact nature of the disease only increases the public’s expectations for monetary policy which could lead to a big disappointment later with an equally serious loss of credibility for the central bank.

Moreover, during balance sheet recessions the effectiveness of monetary policy actually depends on the government’s fiscal policy. This is because when the private sector is deleveraging, money supply shrinks as bank deposits are withdrawn to pay down debt. The only way to keep money supply from shrinking is for the public sector to borrow money. Indeed the US money supply grew after 1933, following the worst balance sheet recession in history, precisely because of government’s New Deal borrowings. Japan’s money supply never contracted after 1990 in spite of massive private sector deleveraging, also because of government borrowings." ("What actions should the fed be taking?", The Economist)

The Fed's resumption of quantitative easing (QE) will not spark another credit expansion nor will it increase inflation expectations. It may ignite another stock market rally, but deflationary pressures will continue to build as households pay-down debt or default on loans they are unable to service. Private sector deleveraging is ongoing and irreversible. When people are deep in the red, they will not borrow no matter how low interest rates are. This is from the New York Fed's "Quarterly Report on Household debt and Credit":

"As of June 30, 2010, total consumer indebtedness was $11.7 trillion, a reduction of $812 billion (6.5%) from its peak level at the close of 2008Q3, and $178 billion (1.5%) below its March 31, 2010 level. Household mortgage indebtedness has declined 6.4%, and home equity lines of credit (HELOCs) have fallen 4.4% since their respective peaks in 2008Q3 and 2009Q1. Excluding mortgage and HELOC balances, consumer indebtedness fell 1.5% in the quarter and, after having fallen for six consecutive quarters, stands at $2.31 trillion, 8.4% below its 2008Q4 peak."

Consumers have reduced spending by a whopping $812 billion, nearly the same amount as Obama's fiscal stimulus (ARRA). No wonder the economy is flatlining. Deleveraging is outpacing growth, which is why congress needs to pass another stimulus bill or the economy will stumble back into negative territory.

British economist John Maynard Keynes spend a great deal of time studying financial markets. He didn't believe that investors were rational or that markets were self correcting. He believed that government had a role to play in mitigating the effects of the business cycle so downturns didn't morph into depressions, and depressions into revolutions. He wanted to refine capitalism--to make it more humane-- because he believed that capitalism was a better guarantor of personal liberty than the other systems. Keynes critics forget that he was a committed capitalist. They prefer to characterize him as a bumbling Teddy Kennedy-type liberal who believed that government largesse was the answer to every problem.

Today it is fashionable to disparage Keynes. His critics tend to label all excessive and wasteful government spending as "Keynesian". Thus, the TARP bailouts were "Keynesian". The AIG handouts were "Keynesian". The Fed's multi-trillion dollar liquidity facilities were "Keynesian". Well-respected academics, historians and central bankers scorn any form of government assistance as "Keynesian". But the fact remains, the best way out of a deep slump is fiscal stimulus. Keynes was right, and that hasn't changed.

To set the record straight: Keynes never advocated "blank check" bailouts for insolvent financial institutions. Nor did he believe that the government should flood the system with easy money so the economy could lurch from one gigantic asset bubble to the next. The people who attribute these policies to Keynes are either misinformed or driven by their own political agenda. Keynes wasn't even a "big spender", in fact, he believed that when the economy was healthy, the budget should be kept in surplus.

Keynes understood the destructive power of inflation and took it seriously. But he also knew that it was absurd to worry about inflation when asset prices, stock indexes, consumer spending, CPI and bonds yields were all plunging. The solution has to fit the problem, and the problem is deflation. That means the government has to step up when consumers and businesses pull back. But that doesn't mean that stimulus is a panacea. It's not; there are other factors involved. Economic stability requires a balance between supply and demand, but the outsourcing of high-paying jobs, stagnant wages and rising unemployment all weaken demand and throw the apparatus off-kilter. So fiscal stimulus is not enough. The only way to rebalance the economy is by rebuilding the middle class and increasing its buying power. That means redistribution via tax policy and collective bargaining. Keynes saw the flaws in capitalism and summed it up like this:

“The outstanding faults of the economic society in which we live are its failure to provide for full employment and its arbitrary and inequitable distribution of wealth and incomes.”

Keynes supported quantitative easing (the Fed's bond purchasing program) as a means of increasing the money supply, but he also understood its limitations. He knew that it wouldn't be particularly effective when consumers are trying to recover from the bursting of a gigantic asset-price bubble. Fiscal stimulus is a much better way to rev up the economy. It bypasses the privately-owned banking system altogether and delivers the money to those who will spend it. Japan learned that fiscal stimulus is the only way to fight deflation. They found out that whenever they cutoff the fiscal stimulus, the economy plummeted. (Inequality is a big part of Japan's problems, too. According to the Wall Street journal, "Japan now ranks roughly 40th in measures of personal income and that the average Japanese is now poorer that the average citizen of Mississippi.") Ultimately, there's no way to balance supply and demand when the greatest portion of the nation's wealth flows to the upper 1% of the population. This upsets the basic equilibrium that's needed to keep the economy strong. The more uneven the wealth distribution, the more government intervention will be required. There's simply not enough demand to keep the economy operating a full capacity. People are just too broke.

OBAMA'S ECONOMICS TEAM: "Frozen in the headlights"

Stocks fell sharply on Thursday (Dow down 144pts.) on news that manufacturing (Philly fed Index) shrank in August beyond analysts expectations. Nearly every category fell including shipments and new orders. The Dept of Labor (DOL) also reported that jobless claims rose 12,000 from last week to an advanced figure of seasonally adjusted initial claims of 500,000. Lastly, Moody's reports that commercial real estate prices slipped 4% in June. According to Calculated risk website, "Commercial real estate values are now down 41.3% from the peak in late 2007." Bond yields on US Treasuries continued to fall on Thursday's news feeding the fears of a double dip recession. Policymakers at the Fed, the Treasury, the White House and the Congress continue to look on impassively while the foundations of the so-called recovery crack before their very eyes. As the stimulus runs out, unemployment will edge upwards, deleveraging and debt liquidation will gain momentum, and the economy will succumb to another vicious contraction. The recession is deepening, but Obama's economics team is still frozen in the headlights.

Comments

chrisitan
22 Aug 10, 07:25

great article

Great article

Fiscal stimulus directed in the right direction is the short term medicine needed IN additon to a re-distribution of wealth via the tax policy....BUT MIKE DON'T YOU at least GIVE PAUSE to ponder that the world is moving in an opposite direction .....i.e supranational corprorations are moving in another direction.....supra national banking giants are looking to prey on emerging country's and OUR ECONOMIC HEALTH requires to much dislocation from the way the world is moiving.

What political will is there to re-distribute wealth via the tax policy in this country and what obstacles do they face.....

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